Tips

Cash tips that your employees receive from your customers may constitute taxable wages for payroll tax purposes. In contrast, noncash tips, such as theater tickets, are never considered wages.

What are "tips?" Tips are defined as payments that customers make without compulsion. Customers should have the unrestricted right to determine the amount of their tips. That is, the amount shouldn't be subject to negotiation or dictated by your own policy. If this isn't the case, the so-called tips may in fact be service charges.

Let's assume you operate a restaurant and do not permit direct tipping. However, on each check you include a "mandatory gratuity," which you distribute among your employees. Such a mandatory charge is not a "tip." And, in all cases it constitutes taxable wages upon its distribution to the employees.

What are your obligations? An employee's cash tips are not taxable wages unless they amount to $20 or more in a calendar month and the employee reports them to you by the 10th of the month following the month in which they were received. Once the $20 threshold has been reached, however, all cash tips are wages, including the initial $20.

You are responsible for withholding income taxes and FICA taxes on reported tips, and for paying the employer's portion of FICA and FUTA taxes on them, even though you have no control over the amount of tips the employees receive. Starting in 2013, you are also required to begin withholding the 0.9% Additional Medicare Tax in the pay period in which you pay wages in excess of $200,000 to an employee. There is no employer match for Additional Medicare Tax.

However, your obligation to withhold the employee's portion of FICA and income taxes is limited to the amount of employee funds under your control (e.g., the non-tip wages you would otherwise pay the employee). If insufficient funds are available, they should be applied to the taxes in the following order:

• first, to the employee's portion of the FICA tax due on the nontip wage payment
• next, to the income taxes that you're obligated to withhold on the nontip wage payment
• next, to the employee's portion of the FICA tax due on the tip income
• finally, to the income taxes that you're obligated to withhold on the tip income

If this process leaves you with insufficient funds to collect the employee's FICA tax, your obligation to withhold the uncollected portion ends. In contrast, any outstanding income tax collections should be withheld from your next payment of wages to the employee.

Also, note that you may be eligible for an income tax credit against the amount of FICA tax you have to pay on your employees' tips.

Employees' reports. Your employees may use Form 4070, Employee's Report of Tips to Employer, and Form 4070A, Employee's Daily Record of Tips, to report their tips to you. You may want to give your tipped employees those two forms and a copy of IRS Publication 1244, which discusses their reporting requirements. Or, you can use some other similar form of your own design.

You are not responsible for verifying the accuracy of the amount of tip income your employees report to you. Rather, the employees are responsible for the accuracy of their own tip reports.

Failure by employee to report tips to employer. If your employees fail to report tips of $20 or more per calendar quarter to you, you can be held liable only for the employer's portion of FICA, and this liability does not arise until the IRS makes a written notice and demand.

Warning If you receive any type of letter from the IRS, be sure to contact your tax advisor right away, to find out your options for responding. In most cases you must respond within a specified time period or lose your rights to contest the IRS's assessment.

Tip rate alternative agreement commitments. If you are a food service employer, you can agree to take certain steps to increase tip reporting compliance by your employees in exchange for a promise by the IRS not to demand more FICA than you determine to be due. To participate in this program, you have to enter into a Tip Rate Alternative Agreement Commitment (TRAC) with the IRS. What does this mean? Basically, under this program, you must agree to:

• Maintain a quarterly educational program that trains newly hired employees and periodically updates existing employees about their tip reporting obligations.
• Comply with all federal tax requirements regarding the filing of returns, paying and depositing of taxes, and maintaining records; and establish employee tip-reporting procedures to ensure accurate tip reporting by your employees.

Legislation specifies that IRS agents can't threaten to audit you in order to convince you to sign a TRAC.

Large food and beverage establishments. Special tip reporting and allocation rules apply to what the IRS considers large food and beverage establishments. These rules require you to file some special information returns with the IRS that, in effect, allocate 8 percent of your gross receipts as tips to your employees, if the employees don't report at least that much in tips. The allocated tips must also be reported on each employee's W-2 form; however, you do not actually pay or withhold taxes on the allocated amounts. They are reported to the IRS for informational purposes only.

• Are you a large food or beverage establishment? The IRS's definition may not mesh with yours.
• If you are one, what special forms must you file?
• How do you allocate to employees the difference between 8 percent of your establishment's gross receipts and the amount of tips reported by the employees?
• Our case study illustrates the allocation process for tips in a large establishment.